Fed Crackdown Threatens Earnings at Capital One

Capital One's (COF Quote) earnings look vulnerable to a government clampdown on the credit card industry practice of repeatedly hitting borrowers with hefty penalties.

Falls Church, Va.-based Capital One has posted bubble-era earnings growth even as the economy has slowed. In the first nine months of the year, per-share earnings surged 36% from a year ago, to $2.88.

That jump was mostly attributable not to the money Capital One makes from interest income, but to the hundreds of millions of dollars in late and over-limit fees paid by borrowers. Many of those fees were charged on subprime accounts, which are loans to people with tainted or incomplete credit histories.

Now, analysts are beginning to wonder what will happen to Capital One's profitability once new federal guidelines on fees take effect. Nervous about the massive growth subprime loans, four Washington banking regulators in July together issued some tough draft guidance on how lenders should manage their credit card accounts and book their provisions against bad loans. Lenders had time to comment on the guidelines, but the regulators are not expected to change the wording significantly in the final version, which could be issued imminently.

Capital One's stock could be hit particularly hard by any reduction in the fees it takes in. Amid rumors that the company is an acquisition target, the stock jumped $3.38, or 11%, to close Thursday at $32.76.

Big Numbers

Bill Ryan, consumer credit analyst at Portales Partners, says that Capital One's 2003 earnings could fall more than 50% below expectations if the new regulations cause the lender to eliminate just one fee on each of its roughly 30 million subprime accounts. (Ryan rates Capital One a sell and his firm doesn't do investment banking.)

Down for the Count Capital One's summer setback

Analysts expect Capital One to make $4.50 next year, but the loss of one fee per account could chop that to around $2, Ryan says, adding that the wording of the federal guidance could lead to Capital One having to dispose of more than one fee.

Capital One didn't comment.

In addition, Capital One specifically has caught regulators' attention. In July, the lender announced that the Federal Reserve and the Office of Thrift Supervision had asked it to enter an "informal memorandum of understanding," effectively a request by the regulators that Capital One address issues that concerned them. The memo led to higher regulatory capital and increases to the bad loan reserve, as well as a commitment to improve management. When the action was revealed, Capital One also publicly disclosed, for the first time, that 40% of its $55 billion loan book is subprime. Both revelations whacked Capital One's once-highflying stock, which has been in the doldrums since.